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On the Road to Independence

America’s powerful growth of unconventional oil and natural gas production is good news for energy consumers, investors and the nation’s exploration and production companies.

The dream of energy independence for the United States of America is fast becoming a reality. And indeed, the energy sector’s oil-and-natural gas exploration and production companies are unequivocally responsible for this major milestone in the history of our nation, industry experts say.

Using advanced technology—horizontal drilling and hydraulic fracturing—to extract natural gas and oil from non-porous shale rock, the E&Ps have launched a true production renaissance over the past decade.

America is growing unconventional oil and natural gas production faster than any other country in the world, many energy analysts point out. Just how close is our nation to energy independence?

“The U.S. is already natural gas independent,” says Pavel Molchanov, an energy analyst with Raymond James & Associates in Houston. “When it comes to oil, in 2005 the U.S. was importing 65% of our crude oil. In 2012, that number was 46%. So, in just seven years, it dropped by almost 20 percentage points. That’s a very big deal. Our forecast for this year is 39%. We think that by 2020, imports will fall to less than 10%. And that’s not too far away.”

Molchanov is certainly not alone in his forecast for oil independence. “Most of the data that we’ll see over the next two to three years will be consistent with the U.S. moving toward energy independence,” says John Dowd, research analyst and portfolio manager with Fidelity Investments, based in Boston. “So from an investing point of view, the idea of energy independence is going to gain credibility pretty consistently over the next several years.”

In an in-depth February 2013 report, “Energy 2020: Independence Day—Global Ripple Effects of the North American Energy Revolution,” Citigroup analysts declare that “a move over the course of the decade in which the United States is transformed from the largest hydrocarbon producer and exporter in the world to self-sufficiency or close to it and in which North America becomes an exporter is big news and transformational.”

The report explains, “A half-decade from now, combined U.S. and Canadian oil output could be in surplus of projected needs. And over the next five years, demand for natural gas in the U.S. should catch up with supply, opening up unexpected opportunities in transportation and igniting a re-industrialization of the country. The probability of North American energy independence is extremely high, and even the prospects of energy independence for the U.S. alone are real. It provides unexpected opportunities for the country’s foreign and trade policy.”

Solid E&P Outlook

Not surprisingly, the outlook for E&P stocks in 2013 is positive and upbeat. After lagging the overall market last year, the E&P Index is now up 8% year over year.

“Investors are seeing the E&Ps provide some long-term value, and we’re seeing a big increase this year in some of them,” says Brian Youngberg, a senior energy analyst with Edward Jones, who is based in St. Louis. “Some are already up double-digits. The E&Ps, especially those focused on shale and with good growth prospects, can be very good investments now.”

In general, E&Ps are clearly demonstrating not only increased efficiency at extracting oil and gas but improvement in their business models and cost structures, analysts note.

“What is new is that the E&Ps are able to deliver significant volume growth and in some cases, figure out ways to do it profitably, and in most cases, figure out ways to reduce their overall cost structure,” Dowd says. “When you fast-forward three to five years, I expect the cost structure to be materially improved and the profitability to be materially higher.”

For the past year, firms have been focusing more on oil production, since oil prices are higher than prices for natural gas. “Firms that produce more oil have greater cash-flow margins than those who do not,” says Jim Dean, vice president of corporate development, Penn Virginia Corp., in Radnor, Penn.

Gas, Shale Growth

In natural gas, the Marcellus area in the Appalachian Mountains from West Virginia to New York has seen the most production growth. The biggest, most successful oil shale areas are the Bakken in North Dakota, the Permian Basin in West Texas and the Eagle Ford in South Texas, which is “the hottest” right now. E&Ps also are ramping up activity in the promising Utica area of Eastern Ohio.

Penn Virginia has been drilling oil wells in the Eagle Ford since 2011. The wells are about 95% oil and liquids. “With oil prices remaining high since 2011 and low operating costs, the economics of the wells are among the best in the U.S.,” Dean says. The firm has quadrupled its original positions in this play and at the same time “steadily improved [its] financial leverage and liquidity metrics.”

The unconventional drilling techniques, pioneered by a small drilling company in the 1980s in the Barnett shale region of North Texas, are responsible for today’s E&P impressive performance. The technology has been continually refined, and now there is another exciting development.

Up until recently, companies have been tapping only one layer of oil. Now, in the Permian Basin, they’ve begun drilling into two or three.

“This is brand new,” says Parag Sanghani, a senior analyst with Salient Partners in Houston. “There is talk that the Eagle Ford has potential for multiple layers, and the Utica looks like it will have at least two to produce from.”

E&Ps have been so successful at producing natural gas—leading in fact to an oversupply—that last year they began focusing more on oil, at the same time, drilling for so-called associated gas, or “wet” gas, which contains oil. (“Dry” does not). These liquids-rich plays have proven to be the right strategy to maximize E&P efforts.

If you visit one of the busiest, most successful shale plays, the upbeat spirit would likely be contagious, industry experts share. At the Eagle Ford, for example, you’d see a multitude of rigs and trucks in motion—a bustling, noisy and industrious scene.

“There is a sense of optimism about what these companies are doing for the county, what they’re doing to help others,” Dowd says. “Most people look at the production growth as something very beneficial for the United States, and there’s a legitimate pride in that. There’s a lot of optimism about the future. They’re excited at what they’re able to do to help U.S. growth. All of this has not been an insignificant contribution to employment in the U.S.”

Stock Selection

Last year, the E&P stocks that performed the best were, generally, the more oil-focused securities. Bright spots this year are likely to be those companies that can live within their means. Analysts say that selectivity is paramount when investing in E&Ps.

“We’re focusing on the E&Ps that can stay disciplined with capital and can fund all or most of their capital spending with internal cash flow instead of having to borrow or issue stock,” Molchanov explains.

For 2013, the biggest driver will be the location of shale plays, says John Freeman, a managing director with Raymond James & Associates, in Houston. “You will see producers who are drilling in the Eagle Ford realizing better returns than producers drilling in the Bakken or the Niobrara plays. You’ll see some exploration in the Utica, as that play develops—and it could be really big.”

Location is important, Freeman adds, because of the cost of drilling. “The Eagle Ford is highly economical because of the amount of oil and gas that’s produced, its proximity to the marketplace and its interconnectivity in terms of pipelines,” he says. “It’s just more cost-effective to drill in the Eagle Ford today, and as a producer you receive more dollars per barrel there than drilling in the Bakken or the Niobrara.”

M&A Expansion

The many opportunities for expansion in the business is an interesting part of the E&P story. “We were very active on the acquisition market last year due to the lower prices of natural gas that created many sellers of producing properties and were able to acquire properties at very inexpensive prices,” explains Brian Begley, vice president of investor relations for Atlas Energy, L.P, in Philadelphia.

“We completed $700 million in acquisitions last year,” Begley says. “Compared to our market capitalization of about $900 million, we were the most active relative to our value. We expect to do the same, if not more, over the next 12 months. The acquisition market is still ripe.”

At the same time, Atlas is also beginning to drill oily plays on its own in several attractive basins, such as the Mississippi Lime region in northwest Oklahoma and southern Kansas, and Marble Falls, which is an offshoot of the Barnett, as well as the Utica shale.

“We’re buying assets from companies forced to shift more to oil drilling. We started our new enterprise with virtually no debt last year,” Begley says. “So that clean slate allowed us, for the right price, to aggressively go after properties that people were anxious to sell. When people are sellers, we’re buyers. We learned a long time ago that it’s smart to buy low and sell high. We lock in forward prices for everything we buy, so we protect ourselves from any further weakness in prices.”

Another E&P firm that has grown through acquisitions is LINN Energy. In 2012, it closed a record $2.8 billion in acquisitions and joint ventures.

Since LINN’s initial public offering in 2006, the company has grown from about $700 million to more than $14 billion (as measured by enterprise value), generating a total return of more than 250%. (LINN formed LinnCo, an MLP, in October 2012 to enhance its ability to raise equity capital for acquisitions and growth.)

Oddly enough, major companies, such as Chevron and Exxon, failed to view shale as providing substantial production growth, so for many years they focused internationally. Only recently have they moved into shale in a big way.

“It’s really the smaller, more nimble companies that have led to this shale revolution that we’ve seen in the last five years,” Youngberg explains.

A Balanced Future

Last year, the E&Ps that did well from an investor standpoint were those with especially strong production growth and that could offset the impact of flat oil prices and low natural gas prices, he notes.

For 2013, the Edward Jones analyst is optimistic. “The sector has done well so far this year. Commodity prices, on average, will be overall higher this year than last year, and some of the companies can start driving their own production growth—get it to pick up after spending so much the last couple of years investing in new wells,” he says.

Exporting natural gas is the next giant step, and plans are under way to do that in the form of liquefied natural gas (LNG). Several companies have in fact applied for licenses. As yet, though, only one firm has received a license; and, at any rate, actual service is four or five years away.

However, that will bring a dramatic spike in natural gas prices, a plus, to be sure, for natural gas stocks, analysts agree. Even now, the gas oversupply is starting to work its way out of the system.

“Gas production is beginning to roll over. This means we’ll see supply and demand come much closer into balance, providing strength to gas prices and therefore to gas-weighted E&Ps,” says Jason Stevens, director of energy research, for Morningstar. “To be sure, there are producers that are capable of earning attractive returns at this level of gas prices. The lowest-cost producers are in a good position.”

In picking E&P stocks, the question is: “Who drills economically, and who makes sure to return that value to shareholders?” Sanghani notes. “Now we are going to see who is efficiently extracting that resource. When we see companies spending their capital on drilling wells, we want to see them do it in an efficient manner.”

Competitive Strengths

A large part of the success some E&Ps are experiencing is attributable to cost management. “Some of the U.S. companies are dramatically improving their cost position and becoming far more competitive vis-a-vis the international competition, and that’s a great tailwind,” Dowd says. “The companies are improving their operations and the success they’re having at reducing their own cost structure. It’s not a statement based on some theory about acceleration in the global economy or on a macro-economic level.”

The E&Ps that have the largest acreage positions and the ability to drill the highest number of wells have “the best chance of being able to reduce their cost structure relative to their peers even on an absolute basis,” the analyst adds.

Even in light of the close reality of energy independence, many environmentalists, opposed to hydraulic fracturing, are attempting to quash drilling. Likely, there will be a compromise in the form of more government regulation.

“These companies want to do it right, and they want to do it as a good neighbor,” Youngberg says. “They want to work with regulators, as long as they can do it without giving away competitive secrets; i.e., disclosing some of the fracking fluids that they use.”

But as Stevens succinctly puts it: “It’s really hard to say ‘energy independent’ and ‘no fracking’ at the same time. You can’t turn your back on water-borne imports without fracking.”

The Keystone XL Pipeline is important to oil independence; and at the moment, it seems as if controversial Phase 4 —from Alberta, Canada, to Nebraska—will be approved by the State Department.

“We think it will get done,” Youngberg says. “There’s a lot of oil trapped in Western Canada that needs to get to market; and if it’s not the U.S. [that gets it], it’s going to be Asia. So, we should work with one of our strongest allies and get it done.”

Now is a fine time to invest in energy in general—and E&Ps specifically, experts say. “We have good prices on the oil side, and some companies are trading relatively cheap compared to the market in terms of cash flow,” Sanghani says. “So selectively, there are some good opportunities in E&Ps today.”